OK, I stole the title. Conjectures and Refutations is the title of a collection of essays by Karl Popper, the great philosopher of the open society. I’m just borrowing Popper’s approach to learning. My conjectures, your refutations. All I hope to do here is talk about things that interest me and see if anyone has anything interesting to say in response.

Wednesday, September 29, 2010

I’ve just finished reading Niall Ferguson’s The Ascent of Money, accurately subtitled A Financial History of the World. The book was completed just as the financial crisis was heating up in 2007, and the author has added an Afterword to the paperback edition to bring things up to date through early 2009 or so.

Ferguson is a British historian with impeccable academic credentials who is also an accomplished popularizer who can make sense out of complex topics for the layman, usually with a slightly new angle. (His The War of the World interpreted the twentieth century with its wars as essentially the losing struggle of the West to maintain its long-term primacy.)

In this book he takes on the history of money and how it has shaped civilization, or perhaps even provided the foundation for civilization. His pithy definition of money (“the crystallized relationship between debtor and creditor”) makes as much sense as any I’ve heard, and he provides two insights that for me are the core of the book.

The first is that financial markets are inseparable from human progress. Not just money, i.e. gold or wampum or any other medium of exchange, but further, markets for buying and selling debt in all its forms and derivatives, are what have made possible economic progress-- meaning the material goods and services that make our lives more comfortable than the cavemen’s. We couldn’t have done it without the bankers.

Bankers are not very popular now, for obvious reasons, so it’s refreshing to be reminded that we need them. Attempts to punish or abolish financial markets generally end in tears. Finance is the “brain of the economy”, in the words of one of Ferguson’s sources, “...a coordinating mechanism that allocates capital... to its most productive uses.” There is an obvious need for a certain amount of regulation, but beyond the enforcement of contracts and punishment of fraud and so forth, we monkey with financial markets at our peril.

Which is not to say that finance always gets it right, witness the current crisis. In his excellent Afterword, which is worth the price of the book all by itself, Ferguson discusses the reasons why financial systems are prone to regular crises. (Capsule summary: people aren’t as rational as classical economic theory assumes. Surprised?) But this brings us to Ferguson’s second key point, the evolutionary nature of economic activity.

An analogy has often been made between an economy and an ecology. Both are highly complex systems with billions of actors producing imperfectly predictable aggregate outcomes, full of feedback loops and selection pressures, prone to unintended consequences when tampered with.

Sadly, a great many people refuse to accept this analogy; the political left swarms with people who are able to acknowledge the above with perfect clear-sightedness as regards an ecology, while stubbornly insisting than an economy requires only a sufficiently competent and ruthless bureaucracy to be shaped to their preferences. A Mugabe or a Chavez can wreck an economy in a hurry, just as unwise farming practices created the Dust Bowl.

Ferguson is smarter than that, and he extends the analogy to discuss the evolutionary nature of an economy. While acknowledging that the analogy is not perfect, not least because because mutations are the result of human decisions (entrepreneurial innovation and regulators’ attempts to provide ‘intelligent design’), he points out that “Financial history is essentially the result of institutional mutation and natural selection.” Firms arise and go extinct; the ones that survive pass on their “genes” (effective business practices), speciation occurs, producing new financial institutions, and so forth.

Just as the natural world has had its epoch-ending asteroid strikes, Ferguson points out previous “major discontinuities” which brought on “mass extinctions”, like the Great Depression. He suggests that the current crisis may be another one, and that the financial landscape that will emerge will be unpredictably different.

This is not an argument for radical laissez-faire: the book is full of accounts of the folly of financiers and the regulatory failures that enabled them. But the fabulous complexity and unpredictability of an economy, like that of an ecology, mean that regulation is always reactive. We’re always playing catch-up, and we need to approach the task with caution: attempts to bully and harass markets into being docile servants of the state are more likely to wound or even kill them than to tame them.

It is the messiness of human life that makes financial markets messy. As Ferguson says, “financial markets are like the mirror of mankind,” and “it is not the fault of the mirror if it reflects our blemishes as clearly as our beauty.”